Bailout 2.0 – What Am I Missing?

OK, let’s try this again.  Since I last commented on the bailout, the Treasury Department has dumped $25 billion into Citi and promised about $300 billion more.  I remember when $300 billion was real money.  Treasury has now spent more than half of the TARP funds.  Who knows how much worse off we’d be if that money hadn’t been spent, but so far it is hard to see it doing much good.  I still think there’s a better, faster, less expensive way to solve the problem, and I don’t understand why we aren’t going there.

In my last post, I described the financial system as a boat that’s leaking below the waterline.  Remember the Titanic?  It was sunk by a hole that was only 12 square feet in size – about 6 feet long and 2 feet wide.  That’s more or less what’s happened to our financial system and, in turn, the economy.  Here’s why:

There are about 50 million residential mortgages outstanding in the US.  Of those, roughly 94% are current – paid on time and in full.  Meanwhile, 6%, or about 3 million loans, are in some stage of default. According to the Chicago Fed, US mortgage delinquency averages around 4%.  That would be 2 million loans.  So there’s the 12-square-foot hole in the boat.  The financial system has been crippled by 1 million delinquent mortgages over and above what history would tell us to expect.  The average US home price is about $200,000.  So if the government simply bought 1 million in-default homes and paid the mortgages off in full, that would cost $200 billion, or about half what we’ve spent on the bailout thus far.

The mechanics of how this ‘relatively’ small problem dragged the entire economy under are pretty well understood.  I won’t repeat them here except to say that it was a collection of falling dominoes, each one of which magnified the impact of the one that fell before it.  Mortgage defaults increased to a level that made it difficult or impossible to determine the economic value of mortgage-backed securities.  Unable to value them, institutions stopped trading them, which drove their market value to zero.  Mark-to-market accounting rules then forced these institutions to value the securities at zero on their books.  This wiped out out trillions to dollars in equity and pushed many of these institutions to, or over, the brink of viability.  When that happened, lenders stopped lending to each other, and to pretty much everyone else.

The Treasury Department is now trying to solve the problem mostly by putting capital directly into banks in the hope that they will start lending again.  Or use up the money to buy other failing banks.  Which will give us more big banks.  When part of the problem was too many big banks.

I still don’t get it. It seems to me that we could pour endless amounts of capital into banks and still not fill up the chasm left by the implosion of the mortgage-backed securities market.  Or the government could intervene directly in the 3 million non-performing mortgages, negotiate the best possible deal with the homeowner, and make up the difference.  At a cost of $200 billion or less, that would fix the 12-square-foot hole below the waterline.  If we did that, then bailing out the rest of the boat might actually work.

I’m not an expert in the financial markets.  The Treasury and the Fed are staffed and run by very smart people who know a lot more about the markets than I do.  (Of course, so were Bear Stearns, Lehman Brothers and Merrill Lynch.)  So what am I missing?  What do the experts know that I don’t?  If you know, please post a comment and tell me!

I’m also going to post this question on LinkedIn and see what some of its 20 million members have to say.  Watch this space.  I’ll report the results here.

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